THE BANKING CRISIS 2007-?: HOW DID WE GET HERE AND WHERE DO WE GO FROM HERE?

1. THE BANKING CRISIS 2007-?: HOW DID WE GET HERE AND WHERE DO WE GO FROM HERE? David T Llewellyn Loughborough University CASS Business School (London), Vienna University of Economics & Business Administration, Consultant Economist, ICAP plc ISDA/PRMIA, London 13th October, 2009

2. “Financial systems were very close to total meltdown” (Strauss-Khan, IMF). “The financial crisis is probably the biggest in history” (Charlie Bean) “This is a once-in-a-century crisis” (Alan Greenspan). “Major sectors of America’s financial system are at risk of shutting down. Without immediate action by Congress, America could slip into a financial panic.” (GW Bush) “Le laisser-faire c’est fini, et la fin d’un monde” (N Sarkosy) “….this largely under-regulated system is collapsing today. ” (P. Steinbruck). “Greatest crisis in the history of financial capitalism” (Lord Turner, Turner Report) 2 2

3. PUNCTURED EQUILIBRIUM IN EVOLUTION • Extinctions • New evolutionary patterns • New models for survival • Not all survivors individually survive

4. CENTRAL THEMES • A transformational banking crisis • Excess financialisation and banking • Banking expanded beyond its marginal social value • Induced by: * banking as a mature industry * financial innovation: CRS instruments * environmental factors * ROE focus in short-term • Impact on: risk assessment/risk pricing/lending/ gearing/cost of capital • Complex layers of causality • Context of structural change

5. Edifice of ideology • Faulty risk models • New bank business models: ultimate cause • Network externalities: implications for regulation • The crisis will pass and normality will return……….but what is the new “normal”? • Transformational at four levels: * size of the banking system * bank business models * financial system structure * Regulatory Regime

6. Equilibrating mechanisms: * higher capital ratios * higher cost of capital * risk assessment * pricing of risk • Impact on credit: volume v. displacement • Not status quo ante but status quo ante ante • Financial innovation (CRS) has efficiency benefits • Baby and the Bathwater

7. STRUCTURAL CHANGE Sharp rise in the pace of financial innovation, Increasing “financialisation” of economies, New banking models More market-centric structure of financial systems, (rise in the role of financial markets relative to institutions in the finance system) Sharp rise in the use of derivatives markets, Emergence of so-called “shadow banks” (hedge funds and structured investment vehicles (SIVs) Growing “funding gap”: wholesale funding 7

8. Globalisation of finance. • Increase in leverage • Intra-system leverage • Reduced liquidity holdings • Increased maturity transformation: banks and others • Power of network externalities • Increased connectivity • Increased complexity of instruments and exposures • Diversification produces less system diversity

9. HOW DID WE GET HERE ? • Proximate causes: * sub-prime defaults & US house prices (2) Environmental: * asset price bubbles * global liquidity * Global savings glut * low/less volatile interest rates * market-centric system * globalisation • Incentive Structures: * bank managers, shareholders, rating agencies, supervisors (4) Ideology

10. (5) Supervision * failure to act against know concerns * lack of macro-prudential regulation & linkages (6) Enhanced network externalities (7) Ultimate causes: * financial innovation and credit risk * new bank business models: SIVs etc * rating agencies * LPHI risks: disaster myopia – dilemma * weak RAMS * corporate governance (8) Risk Models

11. THE IDEOLOGICAL CONTEXTTHE EDIFICE OF IDEOLOGY Rational expectations Efficient markets Markets self-correcting Liberalisation Shareholder Value theory No bubbles

12. BUT LIMITED Systemic: fallacy of composition Behaviour not always “rational” Herding Over-shooting and bubbles Periods of collective euphoria Systemic problems: externalities Incentive structures Dysfunctional expectations Respond to macro environment

13. AN ALTERNATIVE PARADIGM 1. Banks ceased to behave as banks 2. Excess “financialisation” via banks: implicit “subsidy” to banks * excess gearing * under-estimation of risk * under-pricing of under-estimated risk * artificially low cost of capital * perceived safety net * short-termist ROE strategy * faulty risk models * excessive focus on efficient markets hypothesis * collective euphoria * low-probability-high-impact risks (LPHI): disaster myopia 3. Perverse incentive structures within banks 4. Network externalities

14. “IT’S ELEMENTARY DEAR WATSON”(Sherlock Holmes) If any industry is “subsidised” or under-prices its product, it will grow too fast and become too big and to a level that becomes unsustainable without the subsidy.

15. NETWORK EXTERNALITIES • Increased connectedness: fewer degrees of separation • Reduced systemic diversity • Externality of responses • Fallacy of Composition • Derivatives: increased length of network and reduced degrees of separation

16. REGULATION IMPLICATIONS (1) Systemic focus (2) Key institutions in the network (3) Structure of the network

17. NEW MODELS • Bank assets relative to deposits: funding gap • Bank loans relative to sum of RWA • Investments and trading relative to balance sheet • Money market funding and securitisation • Credit derivatives

19. BANK MODELS • Traditional: Originate and hold • Securitisation: Originate and sell • Credit Default Swaps: Originate and insure

20. RESULTBank of England FSR, October 2008 • Inflated balance sheets • Expansion into assets whose underlying value/quality/liquidity were unknown • Over-reliance on wholesale funding • Increased gearing into higher risk assets • Inter-connections not realised

21. Banks stopped behaving like banks

22. POSITIVE VIEW “If risk is properly dispersed, shocks to the overall economic system will be better absorbed and less likely to….threaten financial stability”, (Greenspan, 2002) “the development of credit risk transfer [CRT] has a potentially important impact on the functioning of the financial system. It provides opportunity for more effective risk management promises the relaxation of some constraints on credit availability and allows more efficient allocation of risk to a wider range of entities. The pricing information provided by new CRT markets is also leading to enhanced transparency and liquidity in credit markets.” BIS (2003). “these increasingly complex financial instruments have especially contributed to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter-century ago” (Greenspan, 2002).

23. IMF GLOBAL FSRApril, 2006 “There is a growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient” “The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks”

24. NEGATIVE VIEWS “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal to the financial system.” Warren Buffet, 2002 “[CDOs] are the most toxic element of the financial markets today”, Quoted by Howard Davies (FSA), 2002

25. A VIEW ON FINANCIAL INNOVATON “Not all innovation is equally useful….if the instructions for creating a CDO squared have now been mislaid, we will I think get along quite well without it. And in the years running up to 2007, too much of the world’s intellectual talent was devoted to ever more complex financial innovation whose maximum possible benefit in terms of allocative efficiency was at best marginal, and which in their complexity and opacity created large financial stability risks”. Adair Turner, Financial Services Authority, January 2009

26. RECONCILIATION Increased resilience to small shocks v. Greater danger of LPHI shocks • Herding behaviour • Incentive structures • Speculative leverage • Linkages between markets

27. WHAT WENT WRONG • Not always understood • Not shift credit risk • Rebound via system • Opaque • Transformed nature of risk: credit-liquidity-funding-solvency • Excessive use

28. Good parents do not throw the baby away with the bathwater • Financial innovation • Credit-risk shifting instruments • Efficient markets paradigm

29. NORMAL DISTRIBUTION

30. FAULT LINES IN MODELS • Fat tails are more common than normal distribution • Short time period • Correlation rises when volatility is high • Traditional hedging across assets becomes weaker when most needed • VAR models based on normal distribution • Ignores network externalities • Assumes individual actions do not have systemic implications • Systemic risk may be highest when measured risk is lowest: encourages behaviour which creates systemic risk • Fallacy of Composition

31. PROBABILITY OF OCCURRENCE LOW HIGH LOW  SERIOUSNESS OF OCCURRENCE P R I C E X C R I S I S P O T E N T I A L HIGH

32. 1.0 Probability of a Disaster Disaster Myopia π 0.001 Subjective Actual =π‘ π* 0 t t+m t+n Time

33. DISASTER MYOPIA Availability Heuristic v. Threshold Heuristic

34. RISK MANAGEMENT LESSONS • Silo problem • Portfolio risk • Rams skills at the top • Less reliance on mathematical models • Limitations of VAR models • LPHI risks • Systemic risk issues • Understand the products • Incentive structures: short term profit v. long term value

35. MATHEMATICAL MODELS “Not everything that counts can be counted, and not everything that can be counted counts” (Albert Einstein, 1936)

36. The crisis is transformational

37. A VIEW OF THE FUTURE 1. Size of the banking system 2. Bank business models 3. Financial system structure. 4. Regulatory Regime * Regulation * Supervision * Corporate governance * Market discipline * Incentive structures * Intervention strategies

38. 1. SIZE OF THE BANKING SYSTEM • Enhanced risk assessment • Non-subsidised risk: demand • Higher capital ratios • Higher cost of capital • Penalties on Safety Net access • Incentive structures

39. DISPLACEMENT • Securitisation • Shadow banks • Non-finance companies: supermarkets • Capital market: bank credit to bonds • Credit derivatives?

40. 2. BANK BUSINESS MODELS • Traditional model of banking • Less reliance on wholesale funding • Less reliance on rating agencies • Less complex business structures • Less use of credit derivatives

41. 3. FINANCIAL SYSTEM STRUCTURE • Casino v. Utility: banks as utilities linked to a casino • Investment v. Commercial banking: quid pro quo for rescues • Size of banks • Simpler/more transparent legal structures • Banks as utilities ? • Narrow banking?

42. OBJECTIVES OF THEREGULATORY REGIME 1. Reduce probability of failure 2. Lower the cost of failures 3. Systemic stability

43. 4. STRATEGIC OPTIONS FOR REGULATION 1. Structural regulation 2. Increased regulatory intensity 3. Special Resolution Regime: PCA and pre-insolvency closure 4. Regulatory Regime focus

44. GLASS-STEAGALLINVESTMENT v. COMMERCIAL BANKINGTHE CASE FOR • Risk contamination • Contract with tax-payer • Deposit insurance • Utility banking • Regulation and supervision complexity

45. GLASS-STEAGALL: AGAINST • Not practical: fuzzy and arbitrage • Where is the evidence? • “Problem” business (e.g. securitisation) could end up on DP dimension of the balance sheet • Retail banks also in trouble in the crisis • Can reduce risk • Inefficient: break-up of synergies • Global competition • RAMS superior approach • Specialist investment banks can have systemic dimension: Lehman Brothers • Anti-competitive

46. 4. REGULATION • Higher capital requirements • Emphasis on “true” capital • Leverage ratio • Cyclical capital adjustment • Dynamic provisioning • Regulation by “economic substance”: the ”boundary issue” • Treatment of OBS vehicles and shadow banks • Increased capital against trading books

47. Reward systems and incentive structures • Capital related to “connectedness”? • Liquidity requirements • Core funding ratio ? • Systemic focus: Macro-prudential regulation: capital and provisioning • Penalise systemically important banks • Size penalty? • Increased globalisation focus

48. AN ALTERNATIVE REGULATORY STRATEGY • Rules can be hazardous and costly • Simple rules: gearing ratio ? • Limited risk-sensitivity of capital requirements • Focus on outcomes rather than processes • Focus on system rather than banks • Supervision rather than regulation • Enhanced role for market discipline • Rules on intervention

49. PROBLEMS WITH NO RESOLUTION MODEL Uncertainty and unpredictability Time-inconsistent decisions Bargain for economic rents Political pressures: forbearance Uncertainty over rights and obligations Uncertainty over customers’ access

50. RESOLUTION STRATEGY: REQUIREMENTS Minimal loss/risk to tax-payer Predictable model: not ad hoc No interruption to bank business Shareholders not protected Not create moral hazard for the future Sustain systemic stability Competitive neutrality Avoid bargaining for economic rents Limit claim on Deposit Protection Fund